Making investment is one of the most rational decisions which an investor has to take place because of the significant risks associated with the overall investment process. As a general principle, Investors/shareholders of ABC Ltd shall consider different benchmarks against which the investment decisions need to be made. These benchmarks include the cost of equity capital and rate of returns against which the actual rates earned by the investors are matched in order to determine whether the investments are yielding results or not?
This is important also because of the fact that the investment is just the amount of money held by the investors in shares but it must account for the effects of changes in the market prices of these shares also as considering the traditional volatility of the stock market, prices of shares always fluctuate therefore the corresponding value of the investment made also fluctuate with this change too. In assessing the current value of a stock, there are different models which are used for this purpose.
Two of the most important ones include the dividend Growth Model and Capital Asset Pricing Model. Following sections of the report will discuss both of these models in order to provide a conceptual understanding of the two. Dividend Growth Model Dividend Growth Model is relatively simple in use and is one of the earliest methods to be used for calculating the values of the stock. This model is based on following assumptions: 1. Dividends will grow at a steady and constant rate of growth.
Under this assumption, it is assumed that the dividends offered by the company will grow at a constant rate therefore any abnormal changes in the dividends paid out by the firm are not accounted for under normal circumstances in this model. 2. The equity of the company is considered as perpetuity i. e. company will continue to work in foreseeable future therefore the impacts of any financial distress are not accounted for in the model. Cost of equity or required rate of return under this method is computed by adding different risk premiums to the risk free rate of return.
Since the assumption is that investment shall at least earn a risk free rate of return offered by some government securities and if investors are willing to take on some more risk by investing into the stock markets than they should be compensated for various risks which they take. As such rate of return is achieved by adding following: Rate of return = risk free rate + market risk premium+ inflation premium+… This method is widely used for mature companies with a steady rate of growth however, for companies which show variable growths may not be accurately valued by using this method.
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